Risk-based CAT bond pricing considering parameter uncertainties

ABSTRACT

Catastrophe bonds (CAT bonds) are risk-linked securities used by the insurance industry to transfer risks associated with the occurrence of natural disasters to the capital markets. Current formulations for the pricing analysis do not account for uncertainties in model parameters. Neglecting such uncertainties might lead to assuming risks that are higher than intended. This paper develops a risk-based bond pricing, considering the uncertainties in the model parameters. The proposed formulation allows for the definition of CAT bond pricing based on a fixed accepted level of risk. With the proposed formulation, the probability distribution of the CAT bond default probability can be found for a selected price and, conversely, a price can be selected for a given level of desired default risk. The proposed theory is illustrated with a numerical example.

KEYWORDS:

• CAT bond
• earthquakes
• loss assessment
• Poisson process
• reliability

Disclosure statement

No potential conflict of interest was reported by the authors.

Additional information

Notes on contributors

Lorenzo Hofer

Lorenzo Hofer is a Postdoctoral Researcher in the Department of Civil, Environmental and Architectural Engineering at the University of Padova, Italy. His main research interests are in the area of earthquake engineering, structural reliability, risk and resilience analysis, reinforced concrete structures. His research covers seismic risk assessment for enterprises and productive processes, extreme events modelling and loss analysis for insurance purposes.

Paolo Gardoni

Paolo Gardoni is a Professor and Excellence Faculty Scholar in the Department of Civil and Environmental Engineering at the University of Illinois at Urbana-Champaign, USA. He is the director of the MAE Center which focuses on the creating of a Multi-hazard Approach to Engineering, and the associate director of the NIST-funded Center of Excellence for Riskbased Community Resilience Planning. He is the founder and Editor-in-Chief of the international journal Sustainable and Resilient Infrastructure. He is internationally recognized for his work on sustainable and resilient infrastructure; reliability, risk and life cycle analysis; decision-making under uncertainty; earthquake engineering; performance assessment of deteriorating systems; ethical, social and legal dimensions of risk; policies for natural hazard mitigation and disaster recovery; and engineering ethics.

Mariano Angelo Zanini

Mariano Angelo Zanini is Assistant Professor of Seismic Reliability and Risk Assessment in the Department of Civil, Environmental and Architectural Engineering at the University of Padova. His main areas of research interest are reliability, safety, durability and risk assessment of bridges and reinforced concrete structures, Bridge Management Systems, seismic risk assessment and emergency management, lifelines and network analysis, concrete materials.